Corporate Finance and Risk Management with Trevin Hannibal

K

C

2

C

O

R

P

O

R

A

T

E

F

I

N

A

N

C

E

A

N

D

R

I

S

K

M

A

N

A

G

E

M

E

N

T

w

i

t

h

T

r

e

v

i

n

H

a

n

n

i

b

a

l

(

A

C

M

A

-

U

K

,

C

G

M

A

,

B

S

c

.

(

H

o

n

s

)

,

M

B

A

)

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

Questions in the handout are linked to the following topics

•

S

h

a

r

e

h

o

l

d

e

r

w

e

a

l

t

h

m

a

x

i

m

i

z

a

t

i

o

n

•

F

i

n

a

n

c

i

a

l

a

n

a

l

y

s

i

s

•

C

a

s

h

f

o

r

e

c

a

s

t

i

n

g

•

L

e

a

s

i

n

g

•

C

a

p

i

t

a

l

s

t

r

u

c

t

u

r

e

•

P

r

o

j

e

c

t

a

p

p

r

a

i

s

a

l

/

I

n

v

e

s

t

m

e

n

t

d

e

c

i

s

i

o

n

s

•

F

i

n

a

n

c

i

a

l

V

a

l

u

a

t

i

o

n

s

•

F

i

n

a

n

c

i

a

l

R

i

s

k

M

a

n

a

g

e

m

e

n

t

Introduction Finance

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Stakeholder objectives

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Role of the treasury department

•

Banking

•

Managing liquidity

•

Funding

•

Mitigating currency risk

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

Discuss the role of the treasury department when

determining financing or refinancing strategies

•

in the context of the economic environment described in the

scenario

•

Explain how these might impact on the determination of

corporate objectives.

•

Introduction sentence -  economic environment

•

Inflation zero, fall in interest rate

•

On financing a re-financing options to the treasury

department

•

What is the current situation at CD

•

Can they increase debt ?if so the implications

•

Can they increase equity?  if so the implications

•

Implications to the corporate objectives

•

Can we re-finance? if so implications

•

What will happen to share holders wealth

Introduction

•

The scenario in this question concerns a privately owned

entity based in a holiday destination.

•

Inflation is near zero and interest rates are expected to

fall.

•

The treasury department needs to decide how to deal with

the challenges and opportunities the specific set of

circumstances provide and evaluate the impact on the

entity’s capital structure

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Increase the debt

•

Finance theory suggests that entities should use a certain

amount of debt in their capital structure to lower the cost

of capital.

•

Debt is cheaper than equity because interest payments

(usually) attract tax relief and expected returns are lower.

This is because interest is (usually) secured and providers

of debt do not participate in profits.

•

Here we have a mixture of secured and unsecured debt,

but the entity appears sound and of high credit worthiness

so should be able to borrow at comparatively favourable

rates

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Arguments against debt

•

The opposite argument is that in a period of low and

falling interest rates, fixed rate debt becomes a burden.

Some of the reasons are as follows:

•

The real value of debt is not being eroded when there is low or no

inflation, so one of the benefits of debt disappears.

•

If growth is expected to be modest, debt interest may have to be

paid out of static (or even falling) profits, lowering returns to

shareholders.

•

Although nominal interest rates may fall, they never become

negative, so the real cost of borrowing increases

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Raising equity

•

Raising equity is safer if profits are falling as dividends do

not have to be paid and the shareholders do not get their

money back in a liquidation.

•

However, raising new equity in a private entity is more

difficult than in a public entity and this method of raising

new capital raises many additional issues such as

whether to plan for a public listing or a rights issue and

how to value the shares

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Conclusion

•

The main issue for the treasury department to decide is

what combination of dividend policy and capital structure

is likely to maximize the present value of cash flows to

shareholders.

•

This is where the financing strategies adopted contribute

to the determination of the objectives of the entity

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

Evaluate the appropriateness of CD's current objective

and of the two new objectives being considered.

•

Discuss alternative objectives that might be appropriate

for CD

•

Conclude with a recommendation.

•

Evaluation of the current objective- increase divided

•

Benefits of the current objective

•

Drawbacks

•

Proposed objectives

•

Shareholder wealth max? implications

•

Increasing PAT and ROI? Implications

•

Recommendation

•

Highlight the issues on the proposed objectives

•

Suggest – balance score card

Evaluation of the current objective-

•

Looking only at dividends as an objective has its

limitations, for example dividends could increase while

earnings fall.

•

The dividend ratio therefore needs to be considered

alongside dividend payout. Other objectives mentioned

such as profitability as measured by returns after tax and

return on investment have some advantages.

•

For example they are well understood measures and

recognised guidelines are available in the form of

International Accounting Standards. Also, shareholders

expect and understand profitability.

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Proposed objectives

•

Theory supports the Finance Director, suggesting that

maximisation of shareholder wealth is the only true

objective of the entity but this is now considered an

extreme view.

•

Many entities now establish objectives that aim to

maximise shareholder wealth while recognizing

constraints, legally enforceable or voluntary, imposed by

society.

•

A major problem with this objective in the circumstances

of CD is that this is a private entity that does not have a

quoted share price. Shareholder wealth, as traditionally

valued, is difficult to determine.

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Proposed objectives

•

They are historic and backward-looking;

•

They can be subject to manipulation;

•

A variety of accounting policies are available – even within

Accounting Standards; Tax can be affected by factors

outside the control of managers;

•

They do not take account of non-financial objectives.

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Recommendation

•

Maximisation of shareholder wealth, using the theoretical

definition, is difficult to apply in the circumstances of CD.

However, it would be worth introducing an objective that

incorporates earnings growth as well as dividend growth.

•

A range of objectives could be considered, such as risk-

related returns to investors, but again this is more difficult

with a private entity than one with a share listing.

•

The entity needs to consult its shareholders and, possibly,

consider using a balanced scorecard approach to

determine a range of objectives appropriate for an entity

such as CD.

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Financial analysis

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

Prepare a report to the Finance Director of MAT advising

on whether the entity could be classified as “overtrading”

•

Recommending financial strategies that could be used to

address the situation.

•

Points to consider

•

Recommendations should be based on analysis of the forecast

financial position

•

making whatever assumptions that are necessary

•

Should  include brief reference to any additional

information that would be useful to MAT at this time

•

Increase in sales

•

Increase in cost of goods sold

•

Increase in profit margin

•

Current ratio

•

Quick ratio

•

Sales to net current assets

•

Inventory to revenue

•

Debt Ratio : Debt Equity

•

Gearing – Debt : Debt + Equity

•

Days accounts receivable

•

Days accounts payable

•

Days inventory

•

Capital turnover

•

Revenue: Non-current assets

Operating cycle

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

Report format

•

Introduction

•

Purpose

•

Sections of the report



Discussion of the calculations as symptoms of

overtrading;



Advice on financial strategies;



Other information

•

There is a fall in liquidity, as measured here by the current

ratio=2

⋅

83 to 1

⋅

55.

•

The sales to net-current assets ratio will rise from 5

⋅

5 to 10

indicating a potential overtrading situation.

•

There is expected to be a sharp rise in receivables as

measured by days outstanding. Last year, on average, debtors

were 44

⋅

6 days. The forecast is 60

⋅

3 days

•

either a change in collection policy

•

an expectation that sales will be extended to customers with poorer

credit or payment history

•

A dramatic increase in WC Cycle is not to be seen.

•

MAT is demonstrating some signs of overtrading

•

(current ratio and the ratio of sales to net current assets and days

accounts receivable)

•

The entity is forecasting an increase in its non-current

assets but no increase in long term debt.

•

This suggests these purchases are likely to be financed by

overdraft

•

Overtrading can have serious consequences for any

organization; liquidity problems can result in bankruptcy or

financial distress.

Financial strategies

•

Use more trade credit

•

Reduce credit to customers

•

Consider invoicing customers in their own currency

•

More aggressive debt collection

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

Breakdown of inventory into raw materials, WIP and

finished goods;

•

Cash flow forecast by month;

•

Details of the non-current assets purchases and

depreciation policy;

•

Information on level of bad debts incurred and expected.

a)

Construct a forecast income statement, including

dividends and retentions for the years ended 31

December 2016 and 2017.

b)

Section b)

•

Construct a cash flow forecast for each of the years 2016

and 2017

•

Discuss, briefly, how the company might finance any cash

deficit.

•

There is need to finance a cash shortfall of rs.1,680,000

by the end of 2016.

•

As the shortfall is caused by the purchase of new assets,

there should be no problem increasing the overdraft limit

given the size of the entity.

•

It could be argued that as these are long term assets they

should be funded by long-term finance but the amount is

relatively small compared to the value of the entity.

•

Using your results in (a) and (b) above, 

Evaluate

 whether

EF is likely to meet its stated objectives.

•

EVALUATE

•

As part of your evaluation, discuss whether the assumption

regarding overdraft interest is reasonable

•

Explain how a more accurate calculation of overdraft interest could

be obtained.

•

Return on shareholders’ funds:

•

Achieved in 2015 and unsuccessful in 2016 and 2017

•

The new assets might begin to contribute to an improvement but

they are clearly replacement assets for an existing facility and as

such are unlikely to have a significant impact.

•

Increasing's earnings?

•

The increase in earnings is well below EF’s target for 2016 and

2017 but is moving in the right direction.

•

The removal of the simplifying assumption regarding

overdraft interest can be expected to have a significant

effect on forecast cash flows after tax.

•

the increase in earnings that is observed above is so

small that an increase in overdraft interest in 2016 could

reduce earnings to the point at which earnings actually

decline in 2016 from 2015 levels.

•

Recommended to calculate an Average OD interest based

on average cash balances.

Lease financing

•

Two main types

•

Operating lease

•

Finance lease

•

Lease vs Purchase

•

Lease or buy decision

•

If purchase is it  via equity or debt

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

NPV if purchase

•

Purchase and scrap value are main cash flows

•

Capital allowance should be considered

•

DCF = Post tax COC

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

NPV is finance lease

•

Installments are considered

•

Normal dep and interest are tax deductible

•

DCF = post tax COC

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

NPV if operating lease

•

Installments are considered

•

Total installment is tax deductible

•

DCF = Post tax COC

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

(a)

•

Calculate which payment method is expected to be

cheaper for AB and recommend which should be chosen

based solely on the present value of the two alternatives

as at 1 January 2016

•

Explain the reasons for your choice of discount factor in

the present value calculations.

•

Discuss other factors that AB should consider before

deciding on the method of financing the acquisition of the

system

•

The discount rate that should be used in financing

decisions is the opportunity cost.

•

Finance leases are considered a direct substitute for

borrowing, the opportunity cost of leasing is the after-tax

cost of borrowing

•

 Consideration must be given as to how or when the

borrowings are to be repaid if alternative 1 is chosen.

•

 Tax benefits appear to have a significant influence on

the decision; a sensitivity analysis should be carried out to

determine the impact on the decision if tax rates or

regulations change.

b)

•

Advise the Directors of AB on the following:

•

The main purpose and content of a post completion audit

(PCA).

•

The limitations of a PCA to AB in the context of the POS

system.

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

Importance of PCA

•

It enables a check to be made on whether the performance of the

system corresponds with the expected results.

•

It generates information, which allows an appraisal to be made of

the managers who took the decision to upgrade the system.

•

It can provide for better project planning in the future.

•

Limitation if PCA

•

Sufficient resources are often not allocated

•

They can be time consuming

•

They are sometimes seen as tools for apportioning blame,

•

a) Calculate and recommend which payment method is

expected to be cheaper for BEN in NPV terms.

•

b) Evaluate the benefits that might result from the

introduction of the new TMS.

•

Include in your evaluation some reference to the control

factors that need to be considered during the

implementation stage.

•

Benefits of TMS

•

The primary benefit is that one integrated system will replace a

number of apparently disparate legacy systems

•

Greater security of data

•

More flexibility of operations

•

Takes advantage of technological developments.

•

Control mechanism

•

The PCA should provide a source of information

•

This should improve project control and governance

•

Enable changes to be introduced to put the project back on track in

a timely manner

•

Advise the Directors of BEN on the following:

•

The main purpose of a post-completion audit (PCA):

•

What should be covered in a PCA of the TMS project;

•

The importance and limitations of a PCA to BEN in the context of

the TMS project.

•

P

u

r

p

o

s

e

•

Project control;

•

Improving the investment process;

•

Assisting the assessment of performance of future

projects

•

W

h

a

t

i

s

c

o

v

e

r

e

d

•

It enables a check to be made on whether the

performance of the TMS corresponds with the expected

results

•

It generates information, which allows an appraisal to be

made of the managers who took the decision to upgrade

the system

•

It can provide for better project planning in the future

•

L

i

m

i

t

a

t

i

o

n

s

•

Sufficient resources are often not allocated to the task of

completing PCAs so often are not undertaken

•

They can be time consuming and costly to complete

•

I

f

u

n

d

e

r

t

a

k

e

n

b

y

t

h

e

m

a

n

a

g

e

r

s

o

f

t

h

e

p

r

o

j

e

c

t

,

t

h

e

y

m

a

y

c

l

a

i

m

c

r

e

d

i

t

f

o

r

a

l

l

t

h

a

t

w

e

n

t

w

e

l

l

a

n

d

b

l

a

m

e

e

x

t

e

r

n

a

l

f

a

c

t

o

r

s

f

o

r

e

v

e

r

y

t

h

i

n

g

t

h

a

t

d

i

d

n

’

t

Capital structure -Theory in a nutshell

•

Calculation of Ke

•

DVM

•

DGM

•

CAPM

•

CAPM – deal with

•

Risk free

•

Risk premium

•

The risk premium could be categorized into

•

Diversifiable/Firm Specific/Unsystamatic Risk

•

Non Diversifiable/Market/Systamatic Risk

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Capital structure -Theory in a nutshell

•

Calculation of Kd

•

If the debt is irredeemable

•

Interest yield is considered

•

If the debt is redeemable

•

Yeild to maturity is considered

•

A combination of Ke and Kd is embedded in the WACC

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Calculation of project specific COC

•

Approach 1

•

Calculation of beta ungeared through the beta asset

formula using the proxy companies geared beta (

Removing the financial risk)

•

Re-gear to the companies capital structure

•

The new beta is incorporated to the CAPM formula to

compute the Keg

•

The Keg is substituted to the WACC to compute the

Project specific COC

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Calculation of project specific COC

•

Approach 2

•

Calculation of beta ungeared through the beta asset

formula using the proxy companies geared beta (

Removing the financial risk)

•

The beta ungeared is incorporated to the CAPM formula

to compute Keu.

•

The Keu is substituted to the M&M K

adj

 formula to

compute the Project specific COC

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

Discuss the appropriateness of the two Directors’

suggestions about the discount rate when evaluating the

proposed investment

•

Recommend an appropriate rate to use.

•

 You should support your discussion and recommendation

•

 with calculations of two separate discount rates –

•

 one for each Director’s suggestion.

•

 Show all your workings

•

Director A

•

Comment on the gearing

•

COC of 10.06 or 10.74 toward the NPV

•

Arguments against using WACC?

•

Proposed project is a major diversification

•

Hence WACC does not capture the risk of the new venture

•

Arguments for using WACC

•

The project is marginal, that is, it is small relative to the size of the

entity

•

Gearing doesn’t change drastically

•

Director B

•

The theoretically correct approach

•

Gearings are significantly different from ABC.

•

However, the equity beta is influenced by the level of

financial risk (gearing).

•

Unless the market-weighted gearing of XYZ is the same

as ABC, it is necessary to “ungear” the equity of XYZ.

•

Regear to take account of ABC’s financial risk:

•

Prior or post capital structures can be used for regearing

•

Discuss how ABC’s market capitalisation might change

during the week

•

 the proposed investment becomes public knowledge.

•

N

o

c

a

l

c

u

l

a

t

i

o

n

s

a

r

e

r

e

q

u

i

r

e

d

f

o

r

t

h

i

s

p

a

r

t

o

f

t

h

e

q

u

e

s

t

i

o

n

.

•

EMH – 3 forms and how the price will react if semi-strong form

exists

•

In theory, if the market agrees with ABC’s figures and

confidence in its ability to handle the diversification, the market

capitalisation will increase by the NPV of the venture;

•

Change in price depends on how the market receives the

information – major diversification could be seen as a positive

or negative;

•

Market capitalization will increase if the public perceives its

successful

•

There will be external factors that affect the price/value as well

as what is happening at ABC.

•

Discuss the meaning of the terms “systematic” and

“unsystematic” risk

•

Their relationship to a company’s equity beta.

•

Include in your answer an appropriate diagram to

demonstrate the difference between the two types of risk.

a)

•

Risk that cannot be diversified away is called systematic risk

•

Risk that can be reduced by diversifying the securities in a

portfolio is unsystematic risk.

•

Beta is the measurement of systematic risk estimated by

considering the volatility of an individual share price movement

against the movement in the market as a whole

•

An entity with an equity beta greater than 1 would be expected

to have systematic risk proportionately greater than the risk of

the market( vice versa)

•

Using the CAPM and the information given in the scenario

about CIP and Companies A and B, calculate for each of

CIP’s proposed investments:

•

An asset beta.

•

An appropriate discount rate to be used in the evaluation of the

investment

•

Evaluate

•

The benefits

•

Limitations

•

Of using each of the following in CIP’s appraisal of the two

investments:

•

CIP’s WACC.

•

An adjusted WACC as suggested by the Managing Director.

•

CAPM-derived rates that use proxy (or surrogate) companies’

betas.

•

WACC

•

Easy to understand

•

Theory  does not support using WACC for investment appraisal

•

Discrepancies in capital structure

•

Adjusted WACC

•

suffer from the same problems as the basic WACC

•

easily understood by non-finance people

•

CAPM-derived rates

•

It is based on historical data

•

Comparisons with proxy companies are difficult as they assume

close similarity of activities and business risk

•

CAPM is a single period model, The risk of the investments could

well change over their lives.

•

It is based on historical data and the variance surrounding beta is

large; using the CAPM at all can only provide a rough estimate. It

also assumes that past variability with the market will continue.

•

CAPM assumes only systematic risk needs to be captured as

unsystematic risk has been diversified away.

•

 This might not be true in a single, relatively small private company with few

shareholders, whereas the proxies are listed companies with, presumably, a

large number of unconnected shareholders.

•

Comparisons with proxy companies are difficult as they assume

close similarity of activities and business risk. No two companies are

exactly

 alike and even if the activities seem similar their operations

could be quite different in terms of business risk.

•

Discuss, briefly, how an asset beta differs from an equity

beta

•

And why the former is more appropriate to CIP’s

investment decision.

•

Include in your discussion some reference to how the use

of the CAPM can assist CIP to achieve its financial

objective.

•

Distinguish asset and equity beta

•

Refer to the case

•

Use of CAPM

•

Comparison with the current rate

•

An equity beta is the beta that attaches to a company’s

shares

•

An asset beta reflects business risk assuming a company

is ungeared

•

An asset beta is more useful than an equity beta in Proxy

companies A and B because it incorporates the total

business risk inherent in those companies

•

stripping out the impact of the financing structures of the individual

companies.

•

Companies A and B have been selected as proxy

companies primarily because they have the same

business risk.

•

The asset beta does not take into account the financing

structure of the investments, Therefore, the asset beta

needs to be adjusted. This is achieved by re-gearing the

asset

•

After re-gearing the beta comprises of both Biz and Fin.

Risk.

•

The  CAPM- derived rates calculated in part (b) suggest

that for the investments under consideration lower rates

would be more appropriate than 12%.

•

CIP would have rejected investment opportunities that

would have been profitable and therefore contributed to

the achievement of its objective.

•

On the other hand if the CAPM had suggested rates

above 12% then CIP would not be fully compensating

shareholders for the risks inherent in its investments

•

a)

•

Calculate the current WACC of Claudia (before taking the

project into account).

•

b)

•

Evaluate the project using the current WACC calculated in

part (a

•

Calculate the post-project WACC for Claudia after

adjusting for the NPV of the project and the increased

debt,

•

Discuss your results.

•

Discuss and advise whether the pre-project WACC was

an appropriate discount rate for Claudia to use in this

scenario

.

•

Suitability of the current WACC in project appraisal:

•

The WACC has fallen slightly from 5.13% to 4.95% but there

is insufficient change to invalidate the use of the current

WACC in the evaluation of the project.

•

Risk.

•

There is no indication that the project has a different risk

profile to that of the business as a whole.

•

Upgrading IT systems is in line with normal business practice

for this company and this business sector.

•

Conclusion

•

Therefore the current WACC is considered to be a

suitable discount rate with which to evaluate this project.

However any other non financial factors should be also

taken into consideration.

•

Discuss the key factors that Claudia should take into

account in respect of this project when:

•

assessing customer requirements

•

drawing up an implementation plan

•

Assessing customer requirements

•

essential stage to the success of the project

•

requires careful market research amongst customers and also a review of

competitors’ systems

•

include review of language, security, ease of use, speed of internet access of

customers

•

use market survey at order point – ask customers for feedback when they place an

order through the website

•

Drawing up an implementation plan

•

timetable key processes and dates

•

key tasks allocated to project manager and team members

•

frequent review of progress against the plan to ensure no overrun on timing

•

project manager to monitor actual costs and revenues against budget and take

remedial action to address any problems arising

•

train staff

•

careful testing of the system and trial run before live running

•

parallel running of the new system before closing the old system (if possible)

•

C

a

l

c

u

l

a

t

e

t

h

e

w

e

i

g

h

t

e

d

a

v

e

r

a

g

e

c

o

s

t

o

f

c

a

p

i

t

a

l

o

f

J

K

L

.

•

A

d

v

i

s

e

o

n

t

h

e

a

p

p

r

o

p

r

i

a

t

e

n

e

s

s

o

f

u

s

i

n

g

t

h

e

W

A

C

C

o

f

J

K

L

a

s

t

h

e

d

i

s

c

o

u

n

t

r

a

t

e

i

n

G

O

H

’

s

p

r

o

j

e

c

t

a

p

p

r

a

i

s

a

l

,

•

Including reference to the differences in the financial and non-

financial objectives between the public sector and private sector.

•

A private sector organisation is likely to have very different

financial and non-financial objectives than a public sector

organisation.

•

A private sector organisation will focus on maximising

shareholder wealth by maximising profits

•

A public sector organisation will usually have a greater

focus on non-financial objectives such as:

•

value for money;

•

social benefits (including education and health);

•

environmental benefits (of growing concern);

•

A lower discount rate is appropriate for a public sector

organisation such as GOH because it is not necessary to

make the large returns that shareholders expect in a

private sector organisation.

•

The 4% rate is often set to reflect ‘time preference’, that

is, the preference of society as a whole to receive goods

and services sooner rather than later.

•

Inputs are also different. A public sector organisation

measures returns and benefits of a project in a non-

financial nature (such as improvements in public health)

and so it is appropriate to include estimates of these non-

financial benefits in an appraisal exercise.

•

In addition, the funding structure of JKL and GOH are

completely different. JKL’s WACC will reflect both the high

returns demanded by equity holders and also the cost of

debt whereas GOH will effectively only be funded by debt.

•

Based on the above, using the WACC of JKL as a

discount rate for GOH’s project appraisal is not

appropriate. However other non financial factors should

be considered.

(

i

)

C

a

l

c

u

l

a

t

e

t

h

e

p

r

o

j

e

c

t

N

P

V

f

o

l

l

o

w

i

n

g

g

o

v

e

r

n

m

e

n

t

’

s

g

u

i

d

e

l

i

n

e

s

(

i

i

)

A

d

v

i

s

e

G

O

H

o

n

o

t

h

e

r

i

s

s

u

e

s

t

h

a

t

n

e

e

d

t

o

b

e

t

a

k

e

n

i

n

t

o

a

c

c

o

u

n

t

b

e

f

o

r

e

d

e

c

i

d

i

n

g

w

h

e

t

h

e

r

o

r

n

o

t

t

o

p

r

o

c

e

e

d

w

i

t

h

t

h

e

p

r

o

p

o

s

e

d

p

r

o

j

e

c

t

•

Sensitivity analysis to ascertain the critical variables.

•

 In particular, the social benefits of the health centre should be

considered in depth. These appear to have been factored into

the cash inflows in terms of “perceived social benefits” of

inflows but these are extremely difficult to quantify unless the

government has some established basis of quantification.

•

The relationship of the investment to GOH’s objectives should

be examined.

•

This is a very long term investment that has obvious follow on

expenditure in 15 years time. In this case, 15 years might not

be long enough for the evaluation.

•

The availability of government funding both for the initial

investment and the on-going running costs of the centre.

•

Prioritising the use of government funds – what would

they be used for if not used for the health centre – where

is the greatest need.

•

Alternative strategic approaches could be examined such

as:

•

co-operating with other government agencies

•

provision of the service by the private sector

•

refurbishing existing facilities rather than building new

Adjustment of FOREX to Investment

decisions.

•

Eg:-A Sri Lanka Based company is looking for options for

an investment in US. The expected incremental CF are as

follows

•

Y0 – ($50m)

•

Y1-  $20m

•

Y2-  $25m

•

Y3 - $30m

•

DCF = 12%

•

Current Spot Rate US $1= LKR140

•

The LKR is expected to weaken by 2% per annum

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

Calculate the profitability index and equivalent annual

annuities for all three projects;

•

Explain the usefulness of these methods of evaluation in

the circumstances here

•

Recommend which project(s) should be undertaken.

•

PI

•

The profitability index is the NPV expressed as a

percentage of the initial investment

•

PI is most appropriate when projects are divisible.

•

Indeed, in many cases a PI analysis will identify the

optimum combination of projects.

•

Annual equivalent method

•

This is found by dividing the project’s NPV by the relevant

annuity discount factor.

•

Determines the constant annual cash flow that offers the

same present value as the project’s NPV

•

R

e

c

o

m

m

e

n

d

a

t

i

o

n

•

Since the projects are not divisible a trial and error

method is recommended to arrive at the best combination

•

The combination of projects B&C gives the highest NPV

and PI, but this would exceed the entity’s investment limit

•

The combination of B&C is only marginally above the

investment limit and it might be possible to borrow such a

small amount, relative to the size of the investments

•

If the entity does not wish to exceed the $30m limit under

any circumstances, the only option is to invest in A&C,

even though this is sub-optimal in terms of NPV and, to a

lesser extent, PI.

•

It also leaves balance of $1

⋅

8m to invest elsewhere, or

borrow less.

Question 10 a) ii.

•

Explain the differences between “hard” and “soft” capital

rationing

•

Which type is evident in the scenario here.

•

Discuss, briefly, the advisability of the directors of HIJ

limiting their capital expenditure in this way.

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

Hard capital rationing occurs when external limitations are

applied to the entity, as when additional borrowed funds cannot

be obtained.

•

This might be because there is an economy-wide squeeze on

the availability of new capital.

•

Soft capital rationing is the result of an internal budget ceiling

being imposed on capital expenditure by management.

•

T

h

e

t

y

p

e

i

n

e

v

i

d

e

n

c

e

h

e

r

e

i

s

m

a

i

n

l

y

“

s

o

f

t

”

r

a

t

i

o

n

i

n

g

,

a

l

t

h

o

u

g

h

t

h

e

h

i

g

h

i

n

t

e

r

e

s

t

r

a

t

e

t

h

a

t

m

i

g

h

t

b

e

a

p

p

l

i

e

d

o

n

a

d

d

i

t

i

o

n

a

l

b

o

r

r

o

w

i

n

g

s

u

g

g

e

s

t

s

a

n

e

l

e

m

e

n

t

o

f

“

h

a

r

d

”

r

a

t

i

o

n

i

n

g

.

•

This is a private entity and the Directors may have their own

reasons for sub-optimal investment. Also, the assumption that

funds will be forthcoming for all projects that offer an adequate

return are subject to various qualifications, such as:

•

Differences of opinion on return between lender and borrower;

•

Potential loss of control;

•

Shortage of skills to undertake projects;

•

Conflicting evidence of various ranking methods.

•

You later discover that the discount rate used was

nominal, but the cash flows have been calculated in real

terms.

•

Explain, briefly, how the calculation for NPV should be

adjusted

•

What effect the changes might have and on your

recommendation.

•

Y

o

u

a

r

e

n

o

t

r

e

q

u

i

r

e

d

t

o

d

o

a

n

y

c

a

l

c

u

l

a

t

i

o

n

s

f

o

r

t

h

i

s

s

e

c

t

i

o

n

o

f

t

h

e

q

u

e

s

t

i

o

n

•

If the cash flows are in real terms and the discount rate is nominal

then either the cash flows have to be adjusted for year on year

inflation or the discount rate has to be converted to a real rate

using the formula

•

1 + nominal rate = [(1 + real rate) x (1 + inflation rate)]

•

Whichever approach is taken, and the former is the most

common, the result will be to increase the NPVs.

•

If the cash flows of all three projects are affected by the same

rates of inflation in the same proportions then the ranking of the

projects NPVs will\not change.

•

 However, if the pattern and type of cash flow within each project

is affected by significantly different levels of inflation, then the

ranking may well change.

•

Discuss, with supporting calculations, whether this new

information would change your recommendation using an

APV approach incorporating the NPV in the scenario as

the “base case”.

Answer plan

•

With reference to the APV calculated

•

The best combination of the projects needs to be calculated

•

Where the initial investment should within the budget ceiling

•

The Highest NPV project combination should be taken into

consideration.

•

If there is balance it can be invested elseshere.

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

i

.

•

C

a

l

c

u

l

a

t

e

t

h

e

N

P

V

a

n

d

P

I

o

f

e

a

c

h

o

f

t

h

e

T

H

R

E

E

p

r

o

j

e

c

t

s

b

a

s

e

d

o

n

t

h

e

L

K

R

c

a

s

h

f

l

o

w

s

.

i

i

.

•

E

v

a

l

u

a

t

e

y

o

u

r

r

e

s

u

l

t

s

•

A

d

v

i

s

e

P

E

I

w

h

i

c

h

p

r

o

j

e

c

t

o

r

c

o

m

b

i

n

a

t

i

o

n

o

f

p

r

o

j

e

c

t

s

t

o

a

c

c

e

p

t

.

•

The profitability index (PI) shown above is the NPV

expressed as a percentage of the initial investment, this is

the “net” method.

•

PI is most appropriate when projects are divisible.

However, it is technically acceptable to apply the

profitability index alongside other analysis when

determining the best combination of non-divisible projects

in a capital rationing situation.

•

In many cases a PI analysis will identify the optimum

combination of projects.

•

As all three projects cannot be undertaken given the entity’s

capital expenditure limit of Rs.25 million, it is necessary to

look at combinations of any two projects.

•

The combination of projects A&C gives the highest NPV,

B&C has the highest ranking using PI, and is well within the

company’s investment limit, leaving just over Rs.5 million to

invest elsewhere.

•

A&B breaches the limit of capital available. This combination

also ranks last so PEI might not wish to even consider

sourcing the additional Rs.700,000 required to make both

investments

•

PI should only really be used if the projects being

considered are of equal duration and equal risk.

•

Here we are comparing A + C with B + C. we can be fairly

confident that the top ranking PI combination of B + C is

superior to the highest ranking NPV combination of A + C

assuming that we can make constructive use of the

unused capital.

•

Conclusion: The best investment appears to be a

combination of Projects B and C. however non financial

factors should be taken into consideration.

•

E

x

p

l

a

i

n

t

h

e

a

l

t

e

r

n

a

t

i

v

e

m

e

t

h

o

d

o

f

e

v

a

l

u

a

t

i

n

g

P

r

o

j

e

c

t

C

u

s

i

n

g

a

n

A

$

d

i

s

c

o

u

n

t

r

a

t

e

•

i

l

l

u

s

t

r

a

t

i

n

g

y

o

u

r

a

n

s

w

e

r

w

i

t

h

a

c

a

l

c

u

l

a

t

i

o

n

o

f

a

n

a

p

p

r

o

p

r

i

a

t

e

A

$

d

i

s

c

o

u

n

t

r

a

t

e

.

•

The alternative method involves working with A$ cash

flows and an A$ discount rate.

•

•

The expected movements in the LKR /A$ exchange rate

are taken into account in the adjusted discount rate. The

A$NPV result is then converted into LKR at the spot rate.

•

The  DCF as per this scenario amounts to 7.39%

R

e

q

u

i

r

e

m

e

n

t

c

)

•

D

i

s

c

u

s

s

t

h

e

k

e

y

f

i

n

a

n

c

i

a

l

f

a

c

t

o

r

s

,

o

t

h

e

r

t

h

a

n

t

h

e

N

P

V

d

e

c

i

s

i

o

n

,

t

h

a

t

s

h

o

u

l

d

b

e

c

o

n

s

i

d

e

r

e

d

b

e

f

o

r

e

i

n

v

e

s

t

i

n

g

i

n

a

p

r

o

j

e

c

t

l

o

c

a

t

e

d

i

n

a

f

o

r

e

i

g

n

c

o

u

n

t

r

y

r

a

t

h

e

r

t

h

a

n

t

h

e

h

o

m

e

c

o

u

n

t

r

y

.

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Key factors to consider include:

•

Foreign exchange exposure arising on Project C.

•

Availability of suitable finance. PEI has cash available but

this might not be the most appropriate type of finance in a

foreign investment. Borrowing in A$, if available, would

provide a natural hedge by matching (to a greater or

lesser extent) income streams with interest payments and

A$ denominated assets with liabilities.

•

Risk appetite of shareholders. This is a private company

and the profile of shareholdings is not known but it is likely

that at least some of the shareholders are also directors

or employees of the company.

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

Key factors to consider include:

•

Political risks – the foreign country in which Project C will

be invested is not specified but investment in any foreign

jurisdiction carries some risk.

•

Tax implications – these might have been accounted for in

the net operating cash flows but PEI needs to assess the

impact of differential tax rates and/or whether a double

taxation treaty exists between the two countries.

•

Appropriateness of the discount rate – no indication was

given as to how the 9% was determined.

KC2 with Trevin Hannibal (ACMA-UK,CGMA, BSc.(Hons), MBA)

•

(a)

•

C

a

l

c

u

l

a

t

e

t

h

e

n

e

t

p

r

e

s

e

n

t

v

a

l

u

e

(

N

P

V

)

,

i

n

t

e

r

n

a

l

r

a

t

e

o

f

r

e

t

u

r

n

(

I

R

R

)

a

n

d

(

a

p

p

r

o

x

i

m

a

t

e

)

m

o

d

i

f

i

e

d

i

n

t

e

r

n

a

l

r

a

t

e

o

f

r

e

t

u

r

n

(

M

I

R

R

)

a

s

a

t

0

1

J

a

n

u

a

r

y

2

0

1

7

f

o

r

t

h

e

p

r

o

p

o

s

e

d

p

r

o

j

e

c

t

.

•

D

i

s

c

u

s

s

t

h

e

a

d

v

a

n

t

a

g

e

s

a

n

d

l

i

m

i

t

a

t

i

o

n

s

o

f

M

I

R

R

i

n

c

o

m

p

a

r

i

s

o

n

w

i

t

h

N

P

V

a

n

d

I

R

R

.

•

M

I

R

R

V

s

I

R

R

•

MIRR is intended to address some of the deficiencies of

IRR; notably that it eliminates the possibility of multiple

rates of return and seeks to adjust the IRR so that it has

the same reinvestment assumption as NPV

•

 (ie: that the cash inflows of a project are reinvested at the

company’s cost of capital).

•

MIRR vs NPV

•

The MIRR, like IRR, is biased towards projects with short

payback periods which is not the case with NPV.

•

 It could be argued that this bias is advantageous as a short

payback means that funds are available earlier for

reinvestment

.

•

However, MIRR (again like IRR) gives a rate and as such

gives no indication of the size of a project, whilst NPV does.

•

Ultimately despite its advantages, MIRR does not appear to

be understood or used as extensively in practice as NPV and

IRR.

•

E

v

a

l

u

a

t

e

t

h

e

l

i

k

e

l

y

i

m

p

a

c

t

o

f

t

h

e

p

r

o

j

e

c

t

o

n

M

R

’

s

a

b

i

l

i

t

y

t

o

m

e

e

t

i

t

s

f

i

n

a

n

c

i

a

l

o

b

j

e

c

t

i

v

e

s

a

s

s

u

m

i

n

g

t

h

e

p

r

o

j

e

c

t

g

o

e

s

a

h

e

a

d

.

•

P

r

o

j

e

c

t

’

s

c

o

n

t

r

i

b

u

t

i

o

n

t

o

a

c

h

i

e

v

e

m

e

n

t

o

f

f

i

n

a

n

c

i

a

l

o

b

j

e

c

t

i

v

e

s

•

The proposed investment demonstrates a positive NPV at a

discount rate that reflects the specific risk of the project. As

we would expect with a positive NPV, the project’s IRR and

MIRR show returns greater than this risk adjusted cost of

capital.

•

It should therefore contribute to MR’s main financial objective

to achieve a return on shareholder’s funds of 11%.

•

Borrowing Rs.23 million will however take the company

dangerously close to its objective of a maximum gearing ratio

of 35%.

•

At present its gearing is: 350/ (760+350) = 31.5%,

•

Assuming market value is increased by the NPV of the

proposed project and 50% of the cost is borrowed,

gearing becomes:

•

(350+23)/(760+7+350+23) = 32.7%

•

Gearing based on market values changes day to day and the

market value of securities is affected by external factors as well as

those internal to the company.

•

A financial objective based on such volatile variables is difficult to

monitor or achieve on a regular basis. Gearing based on book

values might be a useful supplementary objective.

•

The NPV of the project will be evaluated by the market once

information is released and this value might be more or less than

MR has calculated.

•

The NPV is heavily influenced by the end-of-project residual value

of the non-current assets and the value of current assets. Also,

three years is a very short time over which to evaluate such a

project. The evaluation should extend over a much longer period,

at least 10 years for a project such as this.

•

a

)

C

a

l

c

u

l

a

t

e

,

a

s

a

t

1

J

a

n

u

a

r

y

2

0

1

7

:

(i) The NPV of the project at CIP’s existing WACC of 10%.

(ii) The NPV of the project at a risk adjusted WACC using

PPP as a proxy company in respect of business risk.

(iii) The APV of the project.

•

B

a

s

e

–

c

a

s

e

d

i

s

c

o

u

n

t

r

a

t

e

•

Under APV to discount the project cash flows we need a

discount rate that assumes that the project is fully funded

by equity.

•

Therefore the discount rate should be the cost of equity

for an all equity financed company. To establish this we

need an asset beta appropriate to the project, which we

have already calculated above as 1.66.

•

This then needs to be applied to the CAPM formula to

establish the ungeared cost of equity

•

We will round this to the nearest whole number –

therefore a rate of 12% should be applied to the cash

flows to establish the base case.

•

Given that this is the same discount rate as above the

base case NPV is therefore negative at Rs. (485,300).

•

b

)

E

v

a

l

u

a

t

e

t

h

e

p

o

t

e

n

t

i

a

l

f

i

n

a

n

c

i

a

l

b

e

n

e

f

i

t

s

o

f

t

h

e

p

r

o

j

e

c

t

.

Y

o

u

r

a

n

s

w

e

r

s

h

o

u

l

d

i

n

c

l

u

d

e

d

i

s

c

u

s

s

i

o

n

o

n

t

h

e

a

p

p

r

o

p

r

i

a

t

e

n

e

s

s

o

f

e

a

c

h

o

f

t

h

e

m

e

t

h

o

d

s

u

s

e

d

i

n

p

a

r

t

(

a

)

t

o

a

p

p

r

a

i

s

e

t

h

e

p

r

o

j

e

c

t

•

Based on considering only the financial benefits, the

project would be rejected under the two NPV methods but

accepted under the APV method.

•

Therefore before making a recommendation we need to

consider the appropriateness of each of the methods in

turn.

•

NPV at existing WACC

•

The company’s existing WACC is not appropriate here as

both the business risk and financial gearing of the project

are different from those of the company itself prior to the

project.

•

The proposed project carries a higher level of risk than

CIP’s current business activities. In addition, the benefit to

the company of the subsidy on the government borrowing

and access to higher levels of debt (leading to higher tax

relief) is project-specific have not been taken into account.

•

NPV at risk adjusted WACC

•

The risk adjusted WACC is superior to the existing WACC

in that it provides an adjustment to reflect the business

risk specific to the project. A proxy company’s beta is used

for this purpose.

•

However, this method does not solve the financing issues

identified previously in the discussion of the use of the

existing WACC.

•

APV

•

APV can be used in situations where a project has special

financing features such as providing access to subsidised

financing or where the financing structure of the project is

more relevant to the project appraisal than the financing

structure of the company itself

•

Where the project represents a new area of business for

the company where a different capital structure is

appropriate).

•

For CIP, the APV approach has the advantage of taking

into account:

•

The NPV of the subsidy on the government borrowing (net of issue

costs).

•

Greater tax benefit due to the higher level of debt funding

supported by the project.

•

By using the ungeared cost of equity derived from the

proxy company, APV is correctly based on the project risk

rather than CIP’s current business risk.

•

A

d

v

i

s

e

t

h

e

d

i

r

e

c

t

o

r

s

o

f

C

I

P

w

h

e

t

h

e

r

t

h

e

y

s

h

o

u

l

d

p

r

o

c

e

e

d

w

i

t

h

t

h

e

p

r

o

j

e

c

t

.

•

A

d

v

i

s

e

o

n

w

h

e

t

h

e

r

t

o

p

r

o

c

e

e

d

w

i

t

h

t

h

e

p

r

o

j

e

c

t

•

Based on APV we should accept this project.

•

We should, however, recognise that this decision relies on

the underlying assumptions of APV analysis, including the

important assumption that it is appropriate to use the

actual gearing level for the project where different projects

support different levels of debt, as appears to be the case

here.

•

Mergers and acquisitions: reasons

•

Increase market share

•

To yield combine economies of scale

•

To gain tax reliefs

•

In order to reduce risk

•

Divestment/ Exit

•

Sell off

•

MBO

•

Spin off

•

(a)

•

Calculate a range of values, in total and per share, for SB.

•

Advise the directors of SB on the relevance and

limitations of each method of valuation to an entity such

as theirs, and in the circumstances of the two alternative

disposal strategies being considered.

•

Recommend a suitable valuation figure that could be used

for a trade sale or an IPO.

•

The following three valuation models are considered

•

Asset based

•

Earnings based

•

Cash flow based

•

The net book value of SB 's net assets is Rs,22

⋅

5 million at

the last balance sheet date.

•

This value has little relevance except in specific

circumstances such as a liquidation or disposal of parts of a

business.

•

In SB’s situation, it has even less relevance than in an entity

with a high level of tangible assets as much of its value is in

employees' expertise, or intellectual capital.

•

It is therefore unnecessary to consider the book value of

assets further. It is sometimes claimed that net asset value

provides a "floor" level valuation, but in the circumstances

here this is unrealistic.

•

The P/E ratio can be viewed as indicative of expected

growth.

•

A relatively high P/E would suggest that investors are

prepared to pay a premium for the entity's shares, based

upon present earnings, because they anticipate growth in

future earnings beyond growth rates expected in

comparable entities.

•

Market capitalisation is not necessarily the true value of

an entity as it can be affected by a variety of extraneous

factors

•

In the case of an unlisted entity, using the P/E ratios of

similar quoted entities take no real account of SB’s

specific circumstances and potential

•

Establishing a level of earnings for SB that is sustainable

is very subjective especially in such a high risk business.

•

DCF/NPV analysis is the theoretically correct method of

valuation as it recognises future cash flows and discounts

them at a rate that recognises their specific risk.

•

Limitations

•

It is based on an entity’s own estimation;

•

In the case here, it is necessary to use an industry cost

of capital, which could be wildly inaccurate for SB;

•

Using perpetuity to value cash flows from 2020 onwards

is a serious over-simplification (although justified in an

examination situation).

•

As discussed, the asset value is largely irrelevant.

•

The P/E basis is a useful benchmark, but is highly unreliable

because of difficulties in comparing SB with the industry.

•

The DCF method is the most likely to be reliable and is

remarkably close to the value provided at the middle of the

P/E range. However, the DCF is heavily influenced by the

use of a perpetuity.

•

 Both methods are flawed, but an estimated valuation of

around Rs.300 million or Rs.60 per existing share could be

considered

•

Advise the directors of SB on the advantages and

disadvantages of a trade sale compared with a stock

market flotation at the present time

•

Recommend a course of action

•

The main advantages of a trade sale are that the

administrative costs are likely to be relatively low

(although legal fees could be high) and the directors will

make a “clean” exit from the entity, even if they are

retained as advisors.

•

The sales value will be known and not subject to the

vagaries of the stock market, which is a major

consideration at the present time, and environmental

issues might have a negative effect on the acceptance of

SB’s entry to the market.

•

A trade buyer is likely to try to value the entity lower than a

sale on an open market as they will no doubt question

growth rates and so on.

•

 However, the value of the NPV of the cash flows is very

likely to increase once they value the cash flows as part of

their own operations, for example economies of scale

might reduce the operating costs

•

The directors might be subject to a hefty capital gains tax

unless they enter into a phased payment deal, possibly

linked to share options in the buying entity.